Those who know me have heard my analogy that if you give Congress the problem “2+2=?”, they will, after stern examination of the problem, return – and defend – the answer “Grapefruit”. It’s as if the problem is in Greek and Congress speaks only Latin. Kind of. Congress is a political animal. When moved to act, Congress will redefine the question in terms of winners and losers, and then answer that question in political terms. Political physics doesn’t work like ours. They don’t see the same universe we do.

This is why government programs are laughable on their face, only randomly perform as intended, and always cost orders of magnitude more than they say. They’re designing fixes that work in their cartoon-physics world, but don’t even resemble workable fixes in the real-world.

As an economy progresses through a recession, capacity threatens payroll – too many people are participating in too few sales. Layoffs ensue. This continues until payroll threatens capacity – too few people participating in too many sales. Layoffs slow and productivity soars – fewer workers per unit of GDP. Fewer doing more. Result: businesses can recover up to pre-recession levels with smaller payrolls – some of the jobs lost will never be back. This phenomenon was noted after the electronic trading crash of 1987, and it was seen after the dot-com crash, and it is happening now. A market economy prefers productivity over payroll. Increased productivity (lessening cost) is increased standard of living (lessening price).

This has always been thus, but beginning in the 1950s, and going into warp speed since the 1980s, technology is permitting cheap and rapid advances in productivity, broadbanding the phenomenon. The rapid advance of technology, generally, geometrically increases the number of applications (intended and unforeseen) becoming available to the manager. A simple example would be the “Go To Meeting” type of platforms out there that allow participants to conduct virtual meetings, bypassing the entire travel and hospitality segments of cost. Having an ideal intranet (any node can connect to all nodes) between customers, branches and suppliers was expensive to point of exclusion to the non-government economy just ten years ago, but is available now for a small monthly fee and an application disc per participant.

This phenomenon will only strengthen with time.

How does Congress see the above situation? The mean, evil business victimized the witless, unprotected voter, er, worker. Cartoon-physics fix? Tax the greedy business (further delaying new hiring) and pay the victimized worker (rewarding the lack of work). Real-world problem? It locks us into a systemically worsening problem that will only see – wait for it – systemic unforeseen additional expenses (and will have done nothing to address the productivity effect). Increased productivity is an emergent behavior of having an opposable thumb and the ability to solve abstract problems. It’s human nature, not something to be “fixed”. We need to realize that the pace and scope of improving productivity have reached levels to which we must adapt (or continually lobby for increased unemployment compensation).

The deep answer to systemically ever-increasing unemployment is education, but that requires parental cooperation. So how does government fix this? It … and I know this will come as a shock to some … can’t. This is our problem.

It must become common knowledge that ever-increasing productivity (which we want[1]) means ever-decreasing jobs at any given work-site. This can only mean that each pre-recession full-employment numbers can be reached only in the presence of above average economic performance (which is, by definition, not sustainable) or increased entrepreneurialism (which is). If, for what ever reason, you can’t get rehired after the economy reaches pre-recession levels, you better be smart enough to start a business. That means that you need to pay attention in school. And that means that parents need to implant the life-long importance of education in their young.

[1] Increasing productivity – increasing efficiency in business – is a societal good. It improves society’s standard of living – the average goods and services available to the average consumer. A vibrant, efficient business community is good for society because there must be a reliable economic base from which to draw the benefits of that society.

And Here We Go

Since New Year’s Eve, the anti-gang unit of the Helmet [CA][1] Police Department has been under attack. It seems the Vagos, California’s largest outlaw motorcycle gang, took umbrage at the attentiveness with which HPD views their activities. The Vagos fund their operations via methamphetamine trafficking and identity theft, and are in violent opposition to restraint. Ho hum. Since the 1950s, outlaw bike gangs have been locked in a Cold War with law enforcement that has occasionally erupted into violent episodes.

Helmet is different.

First, a hole was drilled in the anti-gang unit building’s roof and a natural gas line inserted, filling the building with explosive gases. Then, a contraption rigged to a security gate at their building sent a bullet whizzing within 8” of an officer’s face. In another attack, an IED was attached to a police officer’s unmarked car while he went into a convenience store.

Given that this group targets this police unit, in this way, at this time, in this place, makes me ask if there’s a nexus here to Mexican drug cartels. Well, there is, but I guess I’m asking if it’s a dotted-line or a solid one. Mexican cartels traffic in methamphetamines and identity theft as well as marijuana and cocaine, and this is precisely how they dialogue with Mexican authorities. So, whether it’s animated by, or merely inspired by, the Mexican narco-insurgency, it would seem that Mexico’s little war is crossing the border.

Phoenix is already the city with the world’s second highest number of per capita kidnappings – second only to Ciudad México. Most of those victims are Mexican nationals – in the ongoing war between Mexican cartels operating in the Phoenix area, they keep kidnapping each other’s operatives – and now, either the instructions or just the tactics of the cartels has reached Helmet CA. A Mexican Air Force helicopter, without notice, crossed the border and operated for several minutes over El Paso. There have been numerous firefights at the border between belligerents and authorities, and at least one instance of a standoff between armed elements of the American and Mexican militaries.

The American Southwest, sparsely populated and of tactically interesting terrain, is ideal for large scale clandestine guerilla operations, and it would be ahistoric if a neighboring insurgency didn’t utilize such an advantageous abutting geography. We’ve probably already got more of the Mexican Cartel War than we know.

If we aren’t going to take physical border security seriously, finishing the fence – from the Texas Gulf Coast to the California Pacific Coast – might not be a bad idea.

[1] 90 miles ESE of Los Angeles.

Chronicle of Our Perdicament

I apologize for boring all of you with a look at how and why policy works (or doesn’t) and how it affects the non-government component of society (us). There is a motif to the serial dysfunction of governmental intervention – common threads that lead to increased hazard – that we are, not only not guarding against, but, in some cases, legislating into existence.

Absolute Size. Regardless of the intent or skill of the authors, there is a point of diminishing returns, beyond which the efficacy of a law is inversely proportionate to the size of the bill. Increased size increases opportunities for self-contradiction, unintended consequences, shrinking cost/benefit differential, cronyism exemptions, clandestine non-germane rider clauses, and operational confusion. Vast, sweeping programs invariably produce less and cost more than the salesmen told us they would. Every time. Incredibly, proponents of ObamaCare were fond of holing up Social Security as a shining example of how good government is at running parts of society. Social Security is a confidence game that would make Charles Ponzi blush – it has over $30 trillion in unfunded commitments ($30 TRILLION!) and is dependent upon current donors to pay-in so current recipients can take-out. New investors paying old investors in an enterprise devoid of equity … that’s a Ponzi Scheme.

That’s how government runs big programs.

Complexity. Regardless of the merits of the law, it will be faithfully implemented and enforced inversely proportionate to the operational complexity of the bill. The more convoluted a bureaucratic task, the higher the incidence of corruption and incompetence. Every time. Lon Fuller, long-time Miami law professor, famously postulated eight characteristics a law must exhibit to be considered legitimately binding on the people. Things like not being self-contradictory, being within the citizens’ ability to obey, citizens must know the law exists – but also, a law must be understandable to be legitimately binding. A citizen cannot justly be punished for not obeying something he can’t be assumed to understand. If a bill is complex beyond comprehensibility, it cannot be justified as a law.

There are also social and cultural dynamics animated by crises in general, and by this crisis in particular.

If anyone is interested in the rest of the conversation, it will be available upon completion as a single PDF or DOC document (I’ll keep you posted), but further sections will not be published here.

LHC Update

CERN, the European Organization for Nuclear Research, has turned the Large Hadron Collider back on, after months of repair following a component failure. Its raison d’être is to create – if ever so briefly – thermal and energy densities that existed peri-Big Bang. Watching particle creation and their decay into more and more stable daughter products, producing the universe we see today. In nanoseconds, we will be able to watch the thermal and energy density history of the universe, from Big Bang to now. Because this history will be captured as a matrix of synchronized data streams from thousands of sensors, we can “run the film” forwards and backwards, speed it up or slow it down – we will be able to watch the birth of physics as energy settles-out into material particles containing mass. That mass-giving event is called the “Higgs Field”, the cause of the Higgs Field is called the “Higgs Boson”, a theoretical particle whose existence we have been unable to explore because we couldn’t generate the exotic energy densities within which the Higgs Boson should be permitted to exist. Running full-up, LHC can do that.

On Friday, March 19, CERN announced that LHC was able to accelerate a beam of protons to 3.5TeV (produce an impact energy density of 3½ trillion electron volts). Electron volts provide a way to quantify extremely tiny amounts of energy. By way of demonstration, a trillion electron volts means that a single proton is accelerated to the point that it strikes with an energy approximately that produced by a flying mosquito. The 3.5TeV beam is the most energetic ever created, shattering LHC’s own previous world record of 0.18TeV, achieved last November.

The Large Hadron Collider, two 17-mile-long underground rings located beneath the Swiss-French border near Geneve, will accelerate two proton beams to very high energies, running in opposite directions, and then focus them on a collision-point, generating an energy field equal to the combined energies of the colliding beams. Focusing two 3.5TeV beams on each other, for example, generates an energy field of 7TeV at the collision point. That should take place in the coming weeks, according to CERN.

Last week’s start-up also kicks off what is to be LHC’s longest period of continual operation. Nominally, it will remain on and accelerating for the next 18 to 24 months (which includes a brief programmed shut-down for maintenance by the end of 2010). In 2011/2012, LHC is programmed to be turned off for a year while it undergoes more extensive maintenance and repairs. By that time, however, we should have had runs at full power, raising the collision point to energy densities of 14TeV, the elusive host environment of the Higgs Boson.

“Higgs Field” and “Higgs Boson” are placeholders. They are names given to phenomena we can’t explain using the standard model. There’s an invisible actor in there somewhere, altering the expected results by a consistent, predictable, but unexplained amount. The process of giving mass to matter – a process about which we are utterly ignorant – we call the “Higgs Field”. The relevant environment – the field – within which matter gains mass, if it can be mathematically described, will define the term “Higgs Field”. The precipitous event that triggers a Higgs Field, the “Higgs Boson”, we are postulating, is the spontaneous appearance and decay of a heavy, unstable particle at densities in excess of ~12TeV. Why the cascade of events initiated by the creation of a Higgs Boson causes matter to exhibit mass, we don’t have a clue. We’re hoping to be able to watch that process.

This threatens to be an exciting year for us Geeks – and trust me, it doesn’t get any Geekier than Theoretical High Energy Physics … I laugh at your measly pocket protector … mwahahahahahaha!

Thought for the Day

Speaker Pelosi is fond of saying that “healthcare is a right”, well now that is has been passed into law, either her speechwriter needs to be found and slapped for lying to us, or those who actually wrote the actual bill need to be found and slapped for making us pay for a right!

Pin the Tail on the Economy

While the US housing market lay fallow, the banking sector melting down, and the US auto industry being taken over by government, the House Energy and Commerce Committee was formulating a cap-and-trade bill aimed at reigning-in American carbon release into the atmosphere. Since the beginning of the cap-and-trade process, however, the global warming debate has been complicated by evidence of dishonesty on the part of those working in support of anthroprogenic global warming. So now we are told – with no change in the language – that cap-and-trade is aimed at weaning America from foreign oil.

Working chronologically backwards, there are three basic problems with cap-and-trade, as it stands today – it does nothing to promote domestic production of gas, oil and coal, cheapening its claim to be aimed at foreign oil; CO2 mitigation isn’t responsive to local solutions; and, fiscally, this is a counterproductive time to undertake a vast restructuring of America’s economy.

In general, cap-and-trade is an emissions management mechanism that turns existential regulation over to the marketplace. Government sets an overall carbon emissions target (14% below 2005 levels by 2020, in this case) and then allocates an allowable tonnage of carbon release to each business, calculated to reach that goal. This allotment is “use-it-or-lose-it”, in that you can’t accumulate unused tonnage toward next year’s requirement. If a business doesn’t use all of its allotment, it may sell them on a carbon market in ton increments. Businesses that overshoot their allotment may buy carbon credits from this market at the prevailing price. Businesses that operate outside of their allotment will be subject to stiff penalties. Each year, government reduces the overall (and therefore, the per-business) allowable carbon release. Therefore, each ton of credits on the carbon market is more expensive with time.

Obviously, nothing in this mechanism targets foreign oil, it targets CO2 emissions from whatever source – coal, oil and natural gas – foreign and domestic. Any other claim is either uninformed or disingenuous. Cap-and-trade actually discourages development of domestic petrochemical production, thus, if anything, it encourages continued reliance on foreign sources[1]. There is nothing in cap-and-trade that makes nuclear power generation (the only economically feasible alternative to carbon-based electricity production) any easier to license and operate. Subsidies to alternative energy R&D cannot produce competitive alternatives as fast as carbon-derived energy becomes scarcer and costlier.

The nature of a pollutant plays an important role in the efficacy of methods to control it. The problem in the 1980s was that American power plants were sending up vast clouds of sulfur dioxide (SO2), which was falling back to Earth in the form of [sulfuric] acid rain, damaging lakes, forests and buildings across eastern Canada and the northeastern United States. The squabble about how to fix this problem had dragged on for years. The Clean Air Act of 1990 established a cap-and-trade system to let polluters figure out the least expensive way to reduce their SO2 emissions. At that time, and with this pollutant, the choices were between various exhaust scrubbers and various pre-burn treatments of the feedstock. It has worked because the specific hazards of SO2 emissions fall off dramatically with distance from the source[2]. The detrimental effects of CO2 work at high altitudes and are global in nature. In the absence of internationally universal compliance, a given nation’s decision to hobble its economy with cap-and-trade becomes a question of domestic economic damage versus global environmental benefit.

Because of the current state of global warming science, nobody can say “spend this many billions in the US and the atmosphere will be this amount less warming”. It’s asking us to reduce our standard of living by a known amount in return for an unknown amount of improvement, if any. The estimates by the proponents of antroprogenic global warming range from an increase of 1.1°C to 6.4°C by the end of the century – that’s a margin of error of 527%[3]! It would be questionable under any circumstances to ask American businesses to lower our competitiveness, when two of our chief competitors (India and PRC) aren’t going to do the same, for an indeterminate (if any) improvement in worldwide conditions.

And that brings us to the restructuring of America’s economy at this time. Since virtually all of our cars and trucks, and over half of our electricity are powered by oil and coal, a strategy designed to price oil and coal out of the market will inevitably increase our cost of using energy. Energy costs are highly regressive, as the poorer one is, the higher proportion of one’s income goes to the purchase of energy. The cost of energy affects the cost of everything. Around 10 million people work in the gas, oil and coal industries. We are not yet in the recovery phase of a steep recession. Those are the economic realities facing the timing of this legislation.

Given the degree uncertainty about the effects on the problem (i.e., global warming), and the degree of certainty about the economic effects of voluntarily increasing the cost of American energy production, it would seem wise to delay consideration of this program until such a time as both the science and our economy are on better footing.

EPA has threatened to take this matter under its portfolio if Congress doesn’t act. Either way, enacting this program at this point would be detrimental to any thought of economic recovery and increased hiring. The talk of “creating millions of ‘green jobs’ ” isn’t borne out by empirical evidence – Spain enthusiastically engaged on a green jobs program (the very program upon which ours is based), and they have lost 1.2 jobs for every “green job” they created, and these programs can’t sustain themselves without massive government subsidies[4].

The known realities of imposing this on the American marketplace at this time would require convincing evidence of the necessity of doing it now, in addition to convincing evidence that this program will have the desired effect. Not only will implementing this program before recovery not assist in that recovery, it is almost purpose-built to exacerbate the recession.

The amount of money being committed, and the rate at which these monies are being committed, would seem to be nearing economic irresponsibility. Both sides of the aisle have been telling us that we are in the deepest recession since the Great Depression. By any measure that’s not true, but it is the deepest since the ’87 electronic trading crash. It’s serious because beyond a certain tipping point, recessions become self-sustaining. The layoffs-lack of buying-sinking profits-layoffs cycle feeds on itself proportionately to the depth and breadth of unemployment. The key is actually aggregate disposable income in the markets, but that is driven by the aggregate economic health of the consumer. Anything that increases the cost of doing business or reduces the disposable income of the consumer will depress recovery. Cap-and-trade does both – it raises costs for all businesses; and to the consumer, it looks like a consumption tax.

Until recovery becomes self-sustaining, government intervention into the marketplace should be limited to those that favor recovery – political agendas need to placed on hold until the economy rights itself. Merits of cap-and-trade aside, this is a political decision that not only doesn’t assist recovery, it works against it.

[1] The extraction and refining of coal, gas and oil are not readily or economically susceptible to alternative energy use, making these activities more expensive with time, and thus less competitive with foreign sources with time

[2] Pollution Hotspots, BBC map of areas that suffer from intense local pollution, BBC News, December 13 2004.

[3] Spin, science and climate change, in The Economist [London], March 18 2010.

[4] See E:-Drive/Dailies/Axcess/Cap and Trade/Study on the Effects on Employment of Public Aid to Renewable Energy Sources, Universidad Rey Juan Carlos, March 2009.

Never Waste a Crisis

After a spirited public debate, it was announced that bankruptcy was not an option for the Big Three American automakers – too disruptive to already fragile markets. In December of 2008, Ford said that it shouldn’t need federal help, primarily because it locked up financing years before the credit markets dried up. That same month, the House passed a $34 billion bailout for General Motors, Chrysler and Ford, but it failed to win approval from enough Republicans in the Senate. In late December, GM and Chrysler received a total of $17.4 billion in government [TARP] loans, in return for providing Congress with plans for returning to profitability and to pay back the government.

It is here that the handling of the automakers stopped being an exercise in economics and started being one of applied politics. And that should surprise no one – government is a political animal. Its instincts are political, not pragmatic or economic. This is precisely why it is always dangerous when government tries to commit business. Political wisdom and economic wisdom coincide only randomly. The straits in which we find ourselves serve as testament to that fact.

The point of contention was competitiveness. Feature-for-feature – performance, quality, appointments, etc – American cars were more expensive than their foreign counterparts. And analysis shows that the most expensive components on your car are the people who put it together. Foreign automakers tend to be more highly automated then their American counterparts, and non-union. The combination of more workers per car, and those workers being union, added approximately $1500 per car over a comparably equipped foreign example.

The argument for reorganization (Chapter 11 bankruptcy) was that all those contracts and benefits could be renegotiated by a federal judge, with viability in mind. The argument against was that the UAW didn’t want any part of it.

In March, President Obama insisted that General Motors CEO, Rick Wagoner, would have to step aside as a condition of government bailing out the troubled company. Though I think that was the correct action (see Too Big to Fail, in these pages), it initiated a national conversation about government takeovers of private businesses. This is why I favor the shedding of top officers as a prerequisite for applying to government for a bailout – the process wouldn’t begin with government “firing” them.

On April 30th, Chrysler LLC declared bankruptcy, severing ties with its troubled finance arm. And on June 1, claiming $82.3 billion in assets and $172.8 billion in debt, General Motors declared bankruptcy. Chrysler ended up 60% owned by the UAW and GM 80% owned by the government. Political philosophy aside, an economic case can be made for bailing out a large player in our dwindling manufacturing sector. Unfortunately, none of the actions taken addressed the economic problems GM and Chrysler were experiencing that made them uncompetitive. Each American car still costs ~$1500 more to make than a comparably equipped foreign car. The union had been protected, most of the jobs saved, bondholders zeroed-out, and the taxpayers replaced banks on the hook. This was not a rescue of the automakers, it was a rescue of the unions. Politics not economics.

Too Big to Fail

We had just finished putting somewhere north of a trillion dollars into the credit seizure instigated by the housing collapse, including many features that were very unpopular with the public at large. One of those was the bailout of the by now demonized AIG which was deemed “too big to fail”. The reasoning being that it would be less expensive to prop-up the jobs and services than to let them fall away and deal with the loss of taxes, increased unemployment costs, disrupted insurance and credit markets, and so forth.

At that point in the run of events, sandwiched between the failures of Lehman Brothers and WaMu, it made sense not to force the problems into the insurance sector as well. Given the breathtaking acceleration of layoffs and plant closings, it didn’t seem that the punishment was proportionate to throw a thousand or so more people out of work for the sins of a few. In a pure economic sense, the former argument is the stronger – avoiding another major hit to the credit system would be severe if not catastrophic. In a pure political sense, the latter argument is the stronger – the administration had to appear to be doing all it could to keep companies open and people working.

It’s worth remembering that the credit markets form the cardiovascular system of society. If it stops, society stops. The situation was, at that point, that dangerous.

Well before this point, Congress should have convened three hearings – the Chairmen of the House and Senate Fannie Mae and Freddie Mac oversight committees should have been made to answer for these institutions’ exposure to large volumes of high risk; the Secretary of HUD should have been made to answer for allowing growing distortions in the housing market; and the Chairman of the SEC should have been made to answer for allowing “too big to fail” banks and insurers to gamble significant fractions of their holdings on risky securities. These rather glaring opportunities to exercise genuine regulation were squandered, and that missed opportunity spanned the Reagan, GHW Bush, Clinton and GW Bush presidencies. Those hearings still haven’t been called.

Government should commission studies (RAND, Brookings, etc) on just what constitutes “too big to fail”. If it turns out that some relationship or rule of thumb can be discerned that makes economic (rather than political) sense, this would be very valuable to regulators. If there is such a thing, we need to think about what should be done as a firm approaches that stage of development. Should it be broken up? Should it be sanctioned to stricter regulation?

There should be new rules for government bailouts as well. It should equate to bankruptcy, in that all contracts – supplier, labor, benefits, debts, everything – are up for renegotiation, and the board and chief officers (executive, financial and operating) are out. If everybody else has to prop you up, there should be real penalties, not golden parachutes or continued employment with the firm. Conditions should be draconian enough that companies would rather just try to reorganize through the courts or liquidate. Government bailout should be an actual last resort that must be taken in the national interest, the only excuse for saddling the public at large with paying the bills.

Finger in the Dike

Newscasters had a new catch phrase – “toxic assets” – which was and intellectual sounding way to say “horrible investment”. In the first week of July 2008, Fannie Mae’s and Freddie Mac’s shares plummet on widespread fears that “toxic assets” would lead to insolvency, which would require vast infusions of federal funds. After days of searching frantically for a buyer, Lehman Brothers files for Chapter 11 bankruptcy protection, becoming the first “household name” bank to collapse since the start of the credit crisis. Meanwhile, Merrill Lynch agrees to be taken over by Bank of America for $50 billion.

Then came an incident that gave us the boogeyman. On September 16, The Federal Reserve announced an $85 billion rescue package for AIG, the country’s biggest insurance company, in return for an 80% stake in the firm. It turns out that AIG was the central figure in taking American mortgage backed securities “wide”. Their financial products division was the most active bundler and marketer of these instruments to large American and foreign banks and hedge funds. The media now had its “bad guy”, rather than just blaming a generic “Wall Street” – here was a specific target. And sure enough, before long we had ACORN marching outside their offices, and individual executives (financial product members or not) being threatened with their (and their families’) lives.

Given the gestalt of serial bank failures, tightening credit, layoffs and foreclosures, would a failure of AIG have been catastrophic to the American economy? That’s a coin flip with “Yes” weighted slightly heavier than “No”. The point is, it very likely could have thrown us into an economic slowdown that was truly unknown since the Great Depression – a fate we survived, but if it could be avoided, why not? An AIG failure also would have had grave consequences internationally – worse than we are now seeing. Did AIG act irresponsibly? Absolutely, especially given the supposed financial savvy these executives possessed. AIG not only represents an enormous economic sector of the credit market, it represents an enormous part of the insurance market. A double hit like that could have been psychologically fatal to any recovery in the foreseeable future. Was taking over AIG a prudent government activity? We don’t know yet.

These kinds of things happened to the most sophisticated brokerage houses in the ‘20s, and they happened to the investment banking sector during the ‘90s. These kinds of things happen when conditions are such that “conventional wisdom” is that risk has been eliminated. If not AIG, somebody. This in no way aims to remove blame from AIG, rather to mitigate it. In fact, those closest to the situation – Congress, those who “regulate” Fannie Mae and Freddie Mac, and those who started this whole momentum in 1977 – should have seen the handwriting on the wall when MBSs became the new darling of banks and hedge funds, if not when they witnessed the fanciful mortgage conditions being used to remain CRA-compliant.

Nine days later, the $307-billion Washington Mutual Bank (WaMu) was closed by regulators and sold to JPMorgan Chase. This was the largest American bank failure to date.

On the 25th, Congressional leaders, the Bush White House and Treasury officials came up with a bipartisan plan for a $700-billion bailout of the American financial system, which was rejected by Congress the next day. The Dow Jones plunged 770 points (7%), a record one-day point-fall. Eight days later (October 3rd), Congress passed a reconfigured $700-billion rescue package, 263-171.

The next week saw Germany, Iceland, the European Central Bank, the Bank of England, and the central banks of Canada, Sweden and Switzerland, take €358 billion ($504 billion) worth of actions to shore up their faltering banking sectors. On the 14th, the United States joined in by pledging a further $250 billion to purchase stakes in a wide variety of banks in an effort to restore confidence in the sector. The next day, figures for US retail sales in September show a fall of 1.2%, the biggest monthly decline in more than three years, as hard-up consumers avoid the shops. The figures underscore fears that the wider economy is now being hit by the financial crisis. The Dow Jones falls 7.87% (733 points) – its biggest percentage fall since the electronic trading collapse of 26 October 1987.

It is against this backdrop that Barack Obama is elected President of the United States on November 4th, defeating John McCain 52.9% to 45.7%.

The next week, PRC set out a two-year $586 billion economic stimulus package to help boost the economy by investing in infrastructure and social projects, and by cutting corporate taxes; and Treasury Secretary Paulson said the government had abandoned plans to use some of the $700 billion bail-out money to buy up banks’ “toxic assets” (which was to free up capital for credit) and decided instead to concentrate on improving the flow of credit.

To be fair, it is clear that Treasury had seen that infusions of money hadn’t encouraged banks to lend to each other, let alone consumers, and that government just didn’t know how to get credit going again, hence the “I hope you forgot what we said last month” announcement. Also to be fair, most non-political economists have agreed that the huge influx of money into the markets – through whatever means – had stemmed the tide of panic in the financial sector, a condition necessary for a return to rationality. The crisis wasn’t over, but it had stopped getting systemically worse.

Pop Goes the Weasel

By late 2003 the economy was showing signs of heating up, so the Federal Reserve began raising interest rates at their first 2004 meeting, and between 2004 and 2006 the prime rate rose from 1% to 5.35%. The housing market is extremely sensitive to interest rates anyway, but virtually all those in subprime contracts signed before the 2004 meeting, being past their teaser rate days, were being hammered by increasingly higher payments as rates began rising.

The quick rise of interest rates had an immediate effect on real estate sales, causing housing prices to begin falling. The first sign of trouble was that both extremes – the poorest and the richest – of subprime buyers began defaulting – the poorest because they could barely afford the teaser rates, and the richest because they had jumped into “investment” properties using subprime to acquire second homes, waiting for value to escalate. When payments went up and value went down, both species of over-extended buyer found the turnaround untenable. The second sign of trouble was that the phenomenon was pandemic, not localized to the usual places like LA, San Francisco and Miami. Banks everywhere were feeling the pressure.

And now, all mortgage backed securities, held by financial institutions and hedge funds all over the world, were suddenly teetering on the verge being unviable.

In April of 2007, New Century Financial, which specialized in subprime mortgages, filed for Chapter 11 bankruptcy protection and cut half of its workforce. As it sold off many of its debts to other banks, the collapse in the subprime market began to have an impact at banks around the world. In July, investment bank Bear Stearns tells investors they will get little, if any, of the money invested in two of its hedge funds after rival banks refuse to help it bail them out. Federal Reserve chairman Ben Bernanke follows with a warning that the subprime crisis could cost up to $100 billion. On August 9, French bank BNP Paribas issued bad news about its solvency – blaming mortgage backed securities – all of this triggering a sharp rise in the cost of credit, and made the financial world realize how serious the situation was.

US and European central banks, seeing that the natural reaction of raising interest rates at the beginning of the crisis was having detrimental effects, cut them in an effort to renew lending. But the short-term help does not solve the liquidity crisis – or availability of cash for banks – as banks were using infusions of cash to shore up their own balance sheets, and remained cautious about lending to each other. This lack of credit – to banks, companies and individuals – was threatening recession, job losses, bankruptcies, repossessions, and a resultant rise in the real cost of living.

In October, Swiss bank UBS is the world’s first top-flight bank to announce losses – $3.4 billion – from subprime related investments. Then banking giant Citigroup unveils a subprime related loss of $3.1 billion. Two weeks later, Citigroup is forced to write down a further $5.9 billion. Within 6 months, its stated losses would amount to $40 billion. October ends with Merrill Lynch’s CEO resigning after unveiling a $7.9 billion exposure to bad debt.

As I’m sure we all remember, the next year was a succession of similar news items, as one bank after another announced a pending liquidity crisis. Piecemeal bailouts – mergers and acquisitions with and by larger financial institutions – wasn’t doing the job. Cash inflows were being absorbed just propping up the remaining banks. No one could get credit. Then the 800 pound gorillas entered the room: on September 7 2008, Treasury Secretary Henry Paulson announced that Fannie Mae and Freddie Mac – holders of nearly half of the outstanding mortgages in the US – had debt levels that posed a “systemic risk” to financial stability and that, without action, the situation would only worsen.

The credit markets were unraveling again, this time spawned by governmental unintended consequences.